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Robert Waldmann: Debt and Taxation Series

Desirable incentive effects of income taxation V

Fifth and last. Not relevant to the USA. Back in the day when US unions weren’t totally feeble, MacDonald and Solow wrote a brilliant paper on collective bargaining and tax based incomes policy.

Imagine a world in which firms must negotiation with unions (for example imagine Europe). The unions have two aims — they want high wages and they want high employment in the sector they represent. This means that a GM&UAW right to manage contract which specifies wages and working conditions and allows management to choose output, investment, and employment is Pareto inefficient. It makes sense to specify wages and the level of production (firms must produce more than the amount that maximizes profits given wages).

If unions have power (hah!) and behave optimally (ha!) representing workers in general and not just workers who have lots of seniority and job security (ha ha ha ha ha) then things are better, but not as good as they could be.

If we collectively really want high employment but don’t care about wages in sectors, then we want to give the rational firms and workers modified incentives. This might be because we really care a lot about the unemployed and don’t care so much how high incomes of the employed are. For MacDonald and Solow it is mostly because they think that higher wages mean higher prices so an equal increase in dollar wages in all sectors has no effect on real wages — that is that real wages are really relative wages — always and automatically.

In any case, the proposal is to reward increased employment and penalize increased wages. This changes the efficient choices for the union and firms. In theory it causes higher employment and lower inflation. In practice it is alleged to have worked on the rare occasions in which it was tried.

I ask why penalize increases in wages. The same effect occurs in the model if one penalizes wages (and rewards employment). The focus on the change of wages was natural back when macroeconomists were worried about inflation (paper published 1984). It follows from accepting the existing inter-industry wage structure. It follows from unions being powerful back then so a proposal which would generally punish unionized workers would not get support from Democrats in congress. That was long ago (kids believe me — I was alive back then — things were different — also they still are that way in Italy).

So in the model as written (and published in a top economics journal the AER) the income tax causes increased efficiency. The proposal is to tax income and subsidize employment (that is have an income tax and an EITC).

In theory this should work. In practice it works.

Desirable Incentive Effects of Income Taxation II

This is the second post in a series. I will discuss advantages of income taxation different from the obvious advantage that taking from people with high income hurts them less than taking from people with low income. Here again, I will assume that, in equilibrium, income tax is returned to the people who pay it as a lump sum. I do this to focus on the incentive effects of income taxation.

In standard models, these effects are undesirable and amount to a deadweight loss which is second order in the tax rate. However, the standard models rely on standard assumptions which are completely implausible. They are used, because it is guessed that the policy implications don’t depend on the absurd assumptions. The policy implications always, in fact, follow from the assumptions.

In this post, for a second time, I will relax the assumption that people are 100% purely selfish and care only about their own consumption and leisure. Instead I will assume that people maximize the sum of their pleasure from consumption and leisure plus a constant far less than one times other people’s pleasure from consumption and leisure.

Desirable incentive effects of income taxation I

Cases in which income taxation is preferable to lump sum taxation with the same ex post net transfers.

The main reason for progressive taxation is that the welfare cost of taking money from wealthy people is lower, because they have a lower marginal utility of consumption. I would like to discuss other advantages of income taxation, that is cases in which it can cause an increase in money metric welfare, or, in other words cases in which a distortionary tax and transfer policy is desirable even if, in the end (in the Nash equilibrium) everyone gets a transfer equal to taxes paid.

The incentive effects of taxation can be desirable for many reasons. I will try to list them in a series of posts. One very simple reason is that lower income is typically obtained by providing a goods and services to poorer people. This means that the signal from the market is not ideal – even if people obtain income by providing useful goods and services, the income depends on the usefulness divided by the consumers marginal utility of consumption.

For example, lawyers income depends on the wealth of their clients separately from the validity of their clients cases. For another doctors income depends on insurance coverage of their patients as well as the effectiveness of therapy and the need of the patience. I will address these issues in the second post in the series. In this post, I will assume that agents sell goods not services and that they sell them for the same price to all customers. Even in this case, there is a difference between the income maximizing choice and the most socially useful choice. Some people obtain more income selling luxuries that no one needs, but for which high income people are willing to pay a lot rather than selling necessities which poor people really want, but for which they can pay little.

People often perceive a difference between maximizing income and contributing as much as they can to society. There is nothing odd about this – it follows from absolutely standard assumptions about market prices and simple utilitarianism – economists most standard approach to welfare economics ( which is an approach to social welfare often considered to underestimate the importance of equality).

So far, there is no hint of any reason why the incentive effects of income taxation might be useful. The novel assumption is that people are not perfectly completely selfish. If you would rather see well fed than starving children, then standard economic theory does not apply to you. It is very important to avoid the false dichotomy between the assumption that people are perfectly selfish and that they are perfectly altruistic. I have often read read proofs that people are not perfectly selfish presented as an argument against the assumption that people are partially altruistic. Before going on, the assumption I need can be that people care 100% as much about their own interests as about anyone else’s. Such people would strike us as extraordinarily selfish, but they are not selfish enough for standard theory.

No one argues that people are selfish. Selfishness is almost always assumed in economic models. I can think of a number of justifications. One is that we should hope for the best but plan for the worst – hope that people are altruistic, but design a system which will work if they are perfectly selfish. I see no merit in this argument. In particular, we don’t have to guess, we know people are partially altruistic. Another is that a system designed on the assumption that people are partially altruistic also works if they are selfish – it just isn’t true that if one fears something might be true, then one should assume that it is. Another argument for assuming selfishness is that economists focus on arms length interaction, and altruism is important in interactions other than buying and selling. This post aims to demonstrate that that argument is invalid. A third argument for assuming selfishness is that altruism has benefits which are separate from the benefits of good policy. The main point of this post is that policies which are optimal if people are selfish and Pareto inefficient if people are partially altruistic.

The key paper in the literature on this topic is “” by Lester Thurow. Thurow’s point is that if people are slightly altruistic, then redistribution from the rich to the poor can make everyone happier, can be a Pareto improvement. Rich person A likes the fact that money is taken from rich person B and given to a poor person. The small loss for person B bothers him a tiny amount, the large gain for person C pleases him a small amount. Person A does not want his money to go to the poor, but in a large society the huge amount of benefit to the poor from transfers from all the other rich people can make up for his (not totally) selfish desire to keep what he has. This means that rich people who support progressive taxation and welfare but don’t give all of their money away are not necessarily hypocrites.

Thurow points out that even partial altruism is an externality and if people are partially altruistic, then equality is a public good. Standard arguments combined with the clearly true assumption that people are not completely 100% selfish imply that redistribution from the rich to the poor can be Pareto improving.

These posts are not simply a reiteration of Thurow’s point. I will assume no net redistribution. The tax and transfers will not help the poor directly, however, their incentive effects may help the poor.

This post will assume that people produce goods and can choose whether to produce a necessity or a luxury good. Caring about the benefit of their product for the consumer, they will prefer, other things equal, to produce the necessity. In equilibrium, other things won’t be equal because they can make more money producing the luxury. By reducing that incentive, income taxation can shift production from luxuries to necessities. This can increase welfare. This, in turn, can please everyone because people are partially altruistic (the last point is exactly Thurow’s point).

A tiny simple model after the jump

Kevin Brady’s misleading Wall St. Journal op-ed

by Linda Beale

Kevin Brady’s misleading Wall St. Journal op-ed

Today’s Wall Street Journal (May 6) features an op-ed by Kevin Brady, right-wing Texas Republican who chairs the notorious “Joint Economic Committee” that has been a notorious producer of anti-tax propaganda-driven studies over the years of Republican hegemony in the House. See “Tax Reform Needs Accurate Tax Tables”, Wall Street Journal (May 6, 2013), at A15.

Jeb Bush Says Mitt Romney’s Taxes Are Incredibly High. We Should Elect Bush President in 2016 So That He Can Rectify That.

President Obama won a second term in the White House in part by “dividing the country,” former Florida governor Jeb Bush (R) said in an interview that aired on Sunday morning.

“I think the basic part of his campaign was that those that were successful weren’t paying their fair share, even though we have incredibly high taxes for high income Americans,” Bush said on CBS News’ “Face The Nation.” “I think he ran a campaign of them and us. And it was quite effective, that somehow the Republicans don’t care about the large number of people.”

Bush said in order to win future elections, Republicans have to offer a “compelling alternative” to that narrative, which he said was untrue. The former governor said he sees such an alternative view taking shape.

Bush’s appearance on “Face The Nation” was part of a Sunday show blitz. The former governor, who is promoting a new book on immigration, is appeared [sic] on five Sunday news programs.

Jeb Bush: Obama won reelection by ‘dividing the country’, Sean Sullivan, Washington Post, yesterday

Well, last week’s big Jeb Bush news was all about the book he co-wrote last year with Clint Bolick, a five-star general in the rightwing-litigation wars during the past three decades.  The book is titled Immigration Wars.  In it, Bush, who, pre-Tea Party, had supported a yellow brick road to citizenship for illegal immigrants, reversed that position, making him look sort of like the Wizard of Oz.

This didn’t play well in the news media, or (I suspect) with much of the public, who thought that one Mitt Romney presidential campaign was more than enough, thank you very much.  

Not to worry, though.  Bush quickly explained that he and Bolick wrote that book last year, and, in light of the new recognition by the political right that, like defense spending cuts, this is not an issue worth losing national elections over, he’s changed his mind again.  Slightly. He’s once again okay with a path to citizenship, but only if that path doesn’t reward lawlessness.  By which he apparently was referring to crossing the border illegally and remaining here, not, say, mugging or murdering, although he probably doesn’t want to appear to be okay with those things, either. The path he now favors, at least as of yesterday, is shaped like a pretzel, I guess.  

The original, twisted ones, not the straight ones.  Similar to his own path on immigration issues. Rolled Gold and Snyder’s of Hanover might offer to lend him some sample molds.

As always for celebrity books, the publishing contract included a commitment to publicize the book.  Which undoubtedly sounded like a terrific idea not just to Bush’s publisher but also to Bush himself, back so many months ago.  Like last summer.  So instead of curling up with the Sunday comics on Sunday morning, as he surely would have preferred now that it’s the post-2012 election era, he made the Sunday talk show rounds.  (Actually, Bush might well have spent yesterday morning at home reading the comics; I didn’t watch the shows yesterday, but these days big-name folks pre-tape these interviews, I guess.)  

And, on at least one of those shows, Face the Nation, as the quote above shows, he claimed both that Obama falsely painted Romney’s 47% comment as indicating that somehow the Republicans don’t care about the large number of people, that Paul Ryan’s and Mitt Romney’s Ayn Rand budget proposals fooled people into thinking that somehow the Republicans don’t care about the large number of people, and that we have incredibly high taxes for high income Americans.  

Mitt and Ann Romney’s 13.9% tax rate indeed is incredibly high. And were it not for Obama’s outrageous dividing of the country, a majority of voters would have recognized that and voted for Romney because of his plan to cut income tax rates by 20% across the board.  Partly, of course, as a deficit-reduction technique, but also in order to be fairer to the wealthy–whose taxes would have been reduced hugely.

The election, of course, occurred before the Jan. 1 “fiscal cliff” deal that raised income tax rates on regular income above $450,000 for couples, and regular income above $400,000 for individuals, and that raised rates on investment income–capital gains, dividends, interest–from 15% to 20%.  So maybe Bush was just saying that taxes on the wealthy are now incredibly high, and that at the time of the election they were only very, very high.  As compared with, say, taxes on the wealthy throughout the seven decades before the presidency of his brother.  Including during the presidency and the vice presidency of his father.  And as compared to taxes on the wealthy in virtually every other modern capitalist democracy in the world.  And if you turn the charts and graphs upside-down, that’s clearly the case.

Except for Greece, whose hallmark fiscal policy was the ignoring of tax rates; everyone was entitled, apparently, to pick their own tax rate.  

Uh-oh.

Bush did say in that quote above that in order to win future elections, Republicans will have to offer a compelling alternative to the false narrative that a big problem for this country is spiraling income inequality (a.k.a., dividing the country) and that somehow the Republicans don’t care about the large number of people.  But luckily, he is offering one: We have incredibly high taxes for high income Americans.  

I think it’s going to be a winner!  Whew. Compelling.

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Post edited slightly for clarity after initial posting.

Every State’s State/Local Tax System Taxes the Poor More than the Wealthy–And All Exceed Federal Taxes

by Kenneth Thomas

Every State’s State/Local Tax System Taxes the Poor More than the Wealthy–And All Exceed Federal Taxes

A new report from the Institute on Taxation and Economic Policy (ITEP) shows that in every state in the country, the bottom 20% of households pay more of their income in state and local taxes than does the top 1%. Washington state was the worst, where the bottom 20% pay a whopping 17.3% of their income in state and local taxes. This was followed by Florida at 13.5% and Illinois at 13.0%. Though the report hints at an exception, a reading of their appendix shows that the only one is the District of Columbia.
 
As the report points out, such high taxation increases the burden of poverty on the people who, by definition, can least afford it. Moreover, this runs counter to the federal tax system, which in its overall effect (see table below) is progressive. On average, the top 1% pay federal taxes equal to 30% of their income, compared to 1.1% for the lowest 20%.
 
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Source: Tax Policy Center

Between these two reports, we can see that the bottom 20% of taxpayers pays a much higher portion of their income in state and local taxes than they do in federal taxes. ITEP therefore recommends four major policies to make state and local taxation less regressive.

1) Enact a refundable earned income tax credit for state income tax;
2) Enact property tax circuit-breaker caps for all low-income taxpayers, including renters;
3) Enact other refundable income tax credits for childless households below the poverty level;
4) Enact or increase child tax credits, and make them refundable.

Of course, it should go without needing to be said, but to make federal tax more progressive (think of Mitt Romney and his tax rate below the average 15.1% paid by those in the third income quintile), we should tax capital gains and carried interest the same as ordinary income.

cross posted with Middle Class Political Economist